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Risk and Reward

We mentioned investing involves “risk” on an earlier page, but what exactly does this mean in terms of investing, and what is the trade off between risk and reward?

As you already know, most things in life involve some sort of risk, and these risks need to be managed and balanced, so you can just carry on with your life.

Driving in a car involves risk, so you wear a seatbelt and keep to the speed limit to reduce or manage this risk. Walking to the shops involves risk, and by staying on the pavements and looking and listening as we walk, we are again managing this risk.

From a financial perspective, even keeping money in a bank isn’t 100% risk-free, as the interest rate on a savings account could be lower than the rate of inflation, meaning the spending power of your money goes down over time, and you can’t buy as much each year with the same amount of money.

When I was a child during the mid-70s, my children’s savings bank account paid an interest rate of 12%. Yes, that’s twelve per cent, not 1.2% as is more likely nowadays. However, even that rate would have meant I was losing the spending power of my money, as inflation was running at between 16% and 24% at the time. 

Investing in assets also carries risk. You will be exposed to the uncertainties of the stock markets, the housing market and wider economy, which means the value of your assets and investments, can, and will, rise and fall over time, and you could get back less than you put in at certain points in time.

The rise and fall of financial markets are all normal, and to be expected, which is why the strategy of Pound cost averaging is such a good idea, as is discussed here.

Risk and reward go hand in hand with investing. As a general rule of thumb, the higher the risk profile of your investments, the higher the potential rewards. Whilst lower-risk investments tend to result in lower rewards. This is why it is important to establish your own risk profile, so you know what level of risk you are comfortable in taking, and the potential returns that may be generated from such a level, as well as the potential capital losses you may be exposed to.

Risk and Reward example

For example, risk scales are often shown as a numerical value between 1 and 7, 1 being practically risk-free, i.e. cash, and 7 being the most risky, i.e. emerging market stocks, or some commodities.

The cash investment may have a potential reward of 1% per year, with little downside other than inflation loss, whereas the emerging market stocks may have the potential for a 20% return per year, but will also carry the risk of a potential 20% loss or more per year.

FACT: A low-risk investor, cannot expect a high return with their investments, as there is a risk and reward miss-match.

What risk and reward  profile are you?

As mentioned on a previous page, there are plenty of financial websites that will provide a risk appetite profile for you for free, and I strongly suggest you do so before you make any investments with your money. See examples of the type of risk appetite questions, you need to consider.

As a general overview, I have noted three different types of investor risk profiles below, by way of an example. You may even be able to recognise which end of the risk spectrum you sit, just from these brief descriptions. 

Low risk and reward 

Jane likes the idea of investing for the long term and is keen to put away £100 per month for her future. However, she hates the idea of her money actually losing value, even for a short time, and thinks she would lie awake at night worrying about it.

Medium risk and reward

Richard wants to build a substantial “pot” for later life, and is happy to commit a decent monthly contribution for the next 15 – 20 years. He understands that risk and reward go hand in hand, and is prepared to accept moderate loses in some years, for the opportunity of a decent gain overall. He doesn’t want to risk the total loss of assets and knows he would sleep easier at night, if he knew he wasn’t exposed to high-risk investments.    

  

High risk and reward

Gemma is young and knows she has an investment time span of at least 20 – 30 years, and she also understands that markets rise and fall, but over the long term, generally track higher, although there is no guarantee of this.

She doesn’t mind if her capital loses significant amounts of value during the down years, as she believes the up years will more than compensate for this. She won’t lose any sleep over her investments, and will probably only look at them once a year at most to review.   

Risk and Reward Risk spectrum

Some people are naturally more cautious than others and don’t like taking big risks. However, no investment is risk-free, and in order to achieve long term wealth, and financial freedom, you will have to build a portfolio of assets that sit within the medium to higher end of the risk spectrum, at some point in time.

If you cannot come to terms with this level of risk, then investing probably isn’t for you, and you will have to find another way to reach your goals.

Taking some modest risk to begin with, is a good way of testing your risk appetite, chosen assets, and how the markets behave.

Once you have become accustomed to the ups and downs of the markets and increased your confidence, then you can increase your contributions or increase your level of risk, or a combination of both as your knowledge and experience of risk and reward grows.